The Fuse

Why Previous OPEC Cuts Have Been Successful, and Why This One Might Not Be

by Matt Piotrowski | October 04, 2016

During the second half of 2008, the global economy was in turmoil, with Lehman Brothers collapsing, stock markets tumbling, and the price of oil also falling at a face pace. The world’s top oil consumer, the United States, had officially entered a recession, a downturn that would reverberate throughout the world and continue to deepen in 2009. Against the backdrop of the worst financial crisis since the Great Depression, a large swath of oil demand was wiped out. With prices plunging at an acute pace, after reaching an all-time record of $147 per barrel in the summer, OPEC, without much contention among member countries, agreed to curb output at its December 2008 meeting in Oran, Algeria. The decision was a no-brainer given the circumstances with market direction and demand at that time. From OPEC members’ point of view, the production cut turned out to be a success. Oil fundamentals gradually tightened for the next few years, and the group put a floor under the market—prices steadily rose and ultimately traded above $100 for about three years from 2011-14.

OPEC has to contend with a potential rebound in U.S. shale, which looks more and more likely given that the U.S. rig count continues to rise and producers hedged furiously for 2017 during last week’s rally.

OPEC’s tentative decision last week in Algiers, however, will not produce the same results as 2008’s action for a variety of reasons. The group has to contend with a potential rebound in U.S. shale, which looks more and more likely given that the U.S. rig count continues to rise and producers hedged furiously for 2017 during the rally that followed the OPEC gathering. Open interest and volumes on the NYMEX shot up as the calendar strip for 2017 traded above $50, a sweet spot for shale producers. Moreover, based upon the OPEC agreement, which is expected to be formalized at its November 30 meeting, three major producers—Iran, Libya, and Nigeria—will not be subject to quotas, meaning they can continue to boost production to make up for longstanding outages. Lastly, the cut is almost certainly not big enough to have a significant impact. OPEC is shooting for a target of 32.5 million-33 million barrels per day (mbd), down from current levels of around 33.6 mbd. If members agree to the higher end of that range—the 33 mbd target—the collective cut would only amount to 600,000 b/d. The Saudis, who pumped some 10.6 mbd toward the end of summer, were poised to scale back anyway as the need for summer crude burn diminishes. In other words, the cut, in a market that has been oversupplied for more than two years, hardly makes a dent, particularly if Libya, Nigeria, and Iran all increase.

“We are about to enter a period in which supply additions centered around the Atlantic Basin are about to become more evident in the market.”

Supply is expected to jump well ahead of demand in the fourth quarter, while non-OPEC production is forecast to extend end-of-year gains into 2017. “We are about to enter a period in which supply additions centered around the Atlantic Basin are about to become more evident in the market, with monthly gross additions reaching 250,000 b/d by the end of the year, predominantly from non-OPEC players,” said analysts at Vienna-based JBC said in a note this week. They estimate that non-OPEC supply will rise by some 840,000 b/d quarter-over-quarter in Q4, bringing about a significant oversupply as refineries will reduce crude demand due to seasonal maintenance. Russia, Ghana, and Brazil are expected to add new output, while initial flows from the giant Kashagan field in Kazakhstan, which will eventually reach 1 mbd next year, are supposed to begin by the end of 2016. The new supply is coming on line at a time that demand forecasts are being revised downward and OECD commercial inventories reached a record of 3.1 billion barrels over the summer. This confluence of factors means that any action by OPEC—which has gained tremendously from outages this year—will likely be too little too late to sufficiently rebalance fundamentals.

In 2008, the last time the group curtailed output, OPEC did not have to deal with non-OPEC supply competing to eat into its market share.

By contrast, in 2008, the last time the group curtailed output, OPEC did not have to deal with non-OPEC supply competing to eat into its market share. Supply outside the cartel declined that year and rose by a modest 600,000 b/d in 2009, before the shale boom took off. At that time, too, it was in all members’ interest to rein in output to shore up prices. Now, producers such as Iran, Libya, and Nigeria all see it as their prerogative to increase supply after having to deal with persistent outages. Moreover, OPEC producers were able to agree swiftly to cut by 4.2 mbd, or 15 percent, in 2008 because demand was shattered. “The impact of the grave global economic downturn has led to a destruction of demand, resulting in unprecedented downward pressure being exerted on prices, which have fallen by more than $90 a barrel since early July 2008,” said OPEC in its communique. “Indeed, the Conference noted that, if unchecked, prices could fall to levels which would place at jeopardy the investments required to guarantee adequate energy supplies in the medium-to-long term.” Currently, demand is growing by more than 1 mbd, providing more incentive to cheat so competition doesn’t gain an advantage in battling for market share.

Even though the 2008-9 cut was deemed a success, the group did not publish individual quotas and altogether members failed to cut back to the overall target of 24.8 mbd. What was more, the Saudis bore the brunt of the production pullback, cutting by as much as 1.8 mbd, or by about 15 percent of total productive capacity. The failure of most countries to cut as sharply as originally intended reflected in the new challenges the cartel faces in managing production. It’s also why the largest producer, Saudi Arabia, does not fully trust others to carry their weight in scaling back, one factor that has made the Kingdom hesitant in reining in output during the recent downturn. “We are not banking on cuts… because there is less trust than normal,” said former Saudi Oil Minister Ali al-Naimi in Houston at IHS CERAWeek earlier this year.

Before the 2008 cuts, the cartel had taken significant action almost a decade before. In 1999, following the Asian economic crisis and oversupply on part of OPEC producers, the cartel successfully, after weak attempts the year before, agreed on a round of cuts, pushing the market to the $30 level in 2000 and setting the stage for slimmer inventories and elevated prices throughout the decade. The 1998-9 cuts occurred under market conditions that were similar to what the group would face in 2008—declining demand due to macroeconomic factors and limited competition from non-OPEC, which was set to grow by just 400,000 b/d in 1999.

Reliving the 1980s

The one time OPEC—mainly Saudi Arabia—cut back on supply to deal with a glut similar to today occurred in the 1980s. It didn’t work, however. While the comparisons between today and the 1980s aren’t always apt, both periods dealt with a persistent glut as a result of overproduction from OPEC at a time a flood of non-OPEC supply came online thanks to sustained high prices and governments taking measures to curb demand through new efficiency efforts.

In the 1980s, the Saudis cut output in an attempt to shore up prices, but the market remained weak and prices fell by half.

The result then, like now, was a price collapse. The Saudis cut output in an attempt to shore up prices, but the market remained weak and prices fell by half. From 1980 to 1985, the Kingdom’s production declined by an enormous 6.4 mbd to 3.6 mbd in 1985, which significantly hurt its market share. The 1980s debacle for Saudi Arabia factored in its 2014 decision to hold production steady instead of cutting back alone in an attempt to elevate prices. In the past two years, the Saudis, and OPEC in general, have increased market share at the expense of U.S. shale (see below).

marketshare

A failure is not a foregone conclusion

There’s no guarantee OPEC’s current action will fail, but it certainly faces more headwinds than it has during its last two major cuts.

All that said, the OPEC cut—if details are determined and agreed to in November—is not necessarily doomed in its effort to accelerate a market rebalancing. Some analysts see the lower production from the cartel bringing about a deficit next year. “Now that OPEC has announced a consensus, the implications are that global oil balances would tighten significantly if the target range between 32.5 mbd or 33 mbd is adhered already from the beginning of 2017,” said Rystad’s Bjørnar Tonhaugen, who sees a possible deficit of 1.5 mbd in 2017. Despite the lifeline the OPEC cut has given to shale, it’s unclear how swiftly oil output in the U.S. can rebound, particularly since the industry has seen more than 100 bankruptcies since the beginning of 2015 and over 100,000 workers lose their jobs. In OPEC itself, Iran may not be able to feasibly pump at higher levels in the short run, Libya is still undergoing internal strife, and Nigeria has always been a volatile producer. There’s no guarantee OPEC’s current action will fail, but it certainly faces more headwinds than it has during its last two major cuts.

rystadopec

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